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I confess I heaved a sigh of relief. It's not much fun to go out on a limb and tell people that you think this strategy is a good one then have it drop like the proverbial stone. Lately, the Dow has more closely resembled a balloon -- one blown up and released that is flying all over the place in crazy loops and spirals. Today it shot up like a rocket. Yay. Let's hope it lands on a shelf rather than flying out the door and off the balcony.
Yeah, yeah, this is just one day. When the market drops we say, "Hey, it's just one day. Think long term!" So even though it's tempting to get all excited when you see a big rise, today is still just one day (although yesterday was pretty good, too). Our swift recovery is nice but what does this day really tell us?
The one refrain that was bouncing around all the news feeds this morning is that we are seeing money flow back into the old line stocks and out of the high growth, tech stocks because of investor fears that the tech stocks are over valued. Then this afternoon, the tech stocks rallied and everyone got to celebrate except those who were heavily into genetics stocks -- they are still reeling from Tuesday's sucker punch.
The Nasdaq rally sucker-punched my column today a bit, too. I was all set to "see the universe in a grain of sand" and talk about the growth/value investing cycle as illustrated by today's flow of money from the tech sector back to the old line stocks of the Dow. Oh well, let's talk about it anyway, because even if today wasn't the perfect example, the general idea holds true. Over the years, the market does tend to swing back and forth between these two styles -- sometimes very abruptly.
Growth investors look for companies that have the potential to provide big earnings. They care less about what a company is earning now, and more, much more, about what it could be earning in 10 years. That's a very legitimate way to invest, but picking a company that will dominate its industry in 10 years is not easy, at least not without the benefit of hindsight. The appeal is that when you are right, the payoff is high. The benefits can be high even when you are wrong, as long as you master the trick of getting out at the right time. (Don't ask me how you do that. I've never figured it out.)
Value investors look for companies that are earning cash right here, right now. Of course, they expect the company to continue to earn lots of cash, but they are more interested in a company's proven earnings than in its growth potential. They try to acquire their companies below their intrinsic value so that if they are wrong or the market takes a dive, they have a margin for error. A typical value investor will try to buy a company when the price is low relative to its earnings (the famous P/E ratio). They talk about spending X dollars to buy a dollar's worth of earnings and try to spend as few dollars as possible to buy those earnings.
Since there is only so much money to go around, when investor sentiment favors growth stocks, value-type stocks tend to languish and vice versa.
The Foolish Four is a typical value strategy that uses a mechanical formula to select stocks instead of reading mountains of annual reports. (See The Foolish Four Explained if you aren't clear on the details of the formula.) Since we invest in stocks that are good values, they tend to be somewhat ignored when the market is tipped toward growth and to be highly desirable when that attitude changes.
I don't know if today marks any kind of real change, but what we are seeing is typical of the kind of larger shift that takes place when investors become disillusioned with growth stocks and start looking for companies that actually make money. Today the Dow was up 4.93%, but our Foolish Four were up 6.01%. In other words, the Foolish Four rose 20% more than the Dow as a whole. For the week, the Dow is up 7.07% and the Foolish Four is up 11.05%. Our stocks rose 43% more than the Dow.
It's just one day, one week. It means very little. But the long term history of the strategy shows exactly the same thing. The greatest gains come when the Dow is recovering from a bad year. The Dow rises and the beaten down, ignored, and abused Foolish Four stocks, fly even higher.
Next week tech stocks could start sucking the money out of the Dow again and the process could continue for months or longer. But eventually, balance is restored. I want to be in the Foolish Four when that happens.
Fool on and prosper!